Environmental damage insurance in theory and practice

Date15 August 2002
Published date15 August 2002
AuthorMichael Faure
Michael Faure
In this paper, some particularities of environmental insurance are
addressed. First, the paper summarizes the general conditions of insura-
bility. Then, it is explained why insuring environmental liability may be
difficult. Specifically, the necessity of an adequate risk differentiation may
be difficult to obtain in cases of environmental liability. Then, it is explained
how, at the theoretical level, a move towards different insurance schemes
(notably first party or direct insurance schemes) provides a solution to
problems of insurance of environmental liability. Although the move
towards first party or direct environmental insurance may seem attractive
at a theoretical level, nevertheless a variety of practical questions may
arise. The alternative utilized in practice is not first party insurance
(whereby victims would take out insurance coverage), but a form of direct
insurance, whereby environmental damage is insured directly, that is to
say as soon as damage occurs and irrespective of liability. The paper then
discusses a recent example of such a direct environmental insurance, as
it was applied in the Netherlands. Although this system seems to
have considerable benefits, the major disadvantage lies in the fact that
apparently all insurers in the Netherlands moved to this new environmental
An Introduction to the Law and Economics of Environmental Policy: Issues in Institutional
Design, Volume 20, pages 283-328.
Copyright © 2002 by Elsevier Science Ltd.
All rights of reproduction in any form reserved.
ISBN: 0-7623-0888-5
damage insurance. This raises important questions as to the competitive-
ness of the particular market.
Many have pointed at the fact that the scope of liability of industrial operators
is increasing in Europe as well. ~ This expanding liability also seems to hit the
area of environmental liability and, in combination with an increasing tendency
towards intensified (command and control) regulation, some have argued that
the polluter pays double. 2 A recent white paper on environmental liability,
launched on 9 February 2000 by the European Commission, seems - to some
extent - to confirm this tendency: the white paper proposes a strict (although
non-retroactive) environmental liability for damage caused to biodiversity,
provided that it is caused by dangerous and potentially dangerous activities,
regulated by EC environment related law. 3
One result of the seemingly expanding scope of environmental liability is
that - not surprisingly - this has led to great concern for the European liability
insurers. An often-heard reaction, with many changes in liability law, is that as
a result of these expansions, the environmental liability would become
uninsurable. Whether this expanding environmental liability indeed endangers
the insurability of the liability risk is not the topic I am going to examine in
this paper. 4 An interesting effect of these changes in liability law is, however,
that both insurers and industrial operators seem to be looking for alternatives
to liability insurance to cover environmental risks. Several alternatives have
been developed, going from the use of capital markets to the installation of
compensation funds. 5
There is one particular alternative, which merits a closer look. It concerns
more particularly the tendency in some countries to move away from third party
liability insurance towards first party insurance. It is precisely this tendency that
I would like to examine more closely in this paper. The reason is that this
change from third party towards first party insurance seems at first blush to
correspond nicely with George Priest's suggestion that this would be an
appropriate remedy for the American insurance crisis. 6 Some insurers seem to
have taken Priest's warnings for a liability crisis seriously and the same is
apparently true for the remedies he proposed. One can, especially in the
environmental sphere, notice an increasing tendency towards first party
insurance. This is, by the way, not only the case in the environmental area, but
also, e.g. in occupational health and medical malpractice and an increasing use
of first party insurance is even also discussed in the traffic accident area.
Therefore, this phenomenon definitely merits a closer look.
Environmental Damage Insurance in Theory and Practice
In this paper I will first of all look at the theoretical differences between first
party and third party insurance. The question arises how, at least in theory, the
two differ as far as their ability to prevent environmental harm is concerned as
well as the possibility to provide adequate compensation to accident victims
(Section 2). Then we will take a practical example provided by the Netherlands
since the Dutch insurers recently decided to more or less abolish environmental
liability insurance and change radically towards environmental damage insur-
ance. We will have a critical look at this policy and examine whether this is
indeed an acceptable example, which should be followed by other countries
(Section 3). Obviously at the policy level, several questions arise, which are
important both for the liability and for the first party insurance area. These
policy issues have to do with the question whether insurance coverage should
be made compulsory and also relate to the importance of competition policy to
guarantee fully competitive insurance markets (Section 4). All of these issues
will be addressed using the economic analysis of tort and insurance. The reason
for using the law and economics method is obvious: it provides the adequate
tools to examine critically whether various insurance devices can lead to optimal
prevention and compensation.
A few concluding remarks concludes the paper (Section 5).
In the economics of accident law and insurance the reasons why persons seek
insurance coverage have been explained. The utilitarian approach with respect
to insurance has demonstrated that risk creates a disutility for people with risk
aversion. Their utility can be increased in case of loss spreading or if the small
probability of a large loss is taken away from the injurer in exchange for the
certainty of a small loss. 7 The latter is of course, exactly the phenomenon of
insurance. The risk averse injurer has a demand for insurance; he prefers the
certainty of a small loss (the payment of the insurance premium) whereby the
probability of a larger loss is shifted to the insurance company, thereby
increasing the utility of the injurer. 8 It is remarkable that in this utilitarian
approach of insurance, liability insurance is in the first place regarded as a
means to increase the utility of a risk averse injurer, not so much as a means
to protect victims, as is sometimes argued by lawyers.
The reason an insurance company can take over the risk of the injurer is
well known: because of the large number of participants the risk can be spread

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